Category Archives: Money

The Impact of Federal Reserve Policy on the Multi-family Sector

Editor’s Note: For its sixth post, RealForecasts.com is re-publishing a white paper titled “The Impact of Federal Reserve Policy on the Multi-family Sector”, which was written in March of 2010 and distributed by ING Clarion Partners to institutional investors and consultants.

Although the Fed stopped purchasing agency debt and MBS coincident with the end of QE1 in March of 2010, it resumed its purchases with the commencement of QE2 in November of 2010 and continued purchases through the end of QE2 in June of 2011. These continued purchases further bolstered multi-family lending and capital values and forestalled the risk of reversal in the multi-family property market that was raised by this paper.

The Fed’s third round of quantitative easing (QE3) began in September of 2012. Unlike QE1 and QE2, QE3 does not have a defined timeframe and will reportedly continue until the employment market improves. Combined with purchases of long-term Treasuries under “Operation Twist”, which is designed to drive down long-term interest rates, since September of 2012 the Fed has been buying $85 billion of assets per month.

The Impact of Federal Reserve Policy on the Multi-family Sector

Jeffrey J. Peshut, M. Gregory Chicota, David J. Lynn, PhD, Tim Wang, PhD, Bohdy Hedgcock

March, 2010

Executive Summary

We believe that the Federal Reserve’s explicit support for housing-related government-sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Home Loan Banks – has helped avert a more severe fall in housing values. It has also helped to bolster multi-family lending and capital values. This support appears to be waning, however, as the Fed has announced an end to the programs in March. This policy shift will likely impact the availability and cost of debt for multi-family properties, which may have a spillover effect on property valuations.

Overview

In November of 2008, the Federal Reserve announced a $600 billion program to purchase the direct obligations of housing-related GSEs — Fannie Mae, Freddie Mac, and the Federal Home Loan Banks — and mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. According to the Fed, the action was taken to reduce the cost and increase the availability of credit for the purchase of houses, which was expected to support housing markets and foster improved conditions in financial markets more generally.

Purchases of up to $100 billion in GSE direct obligations under the program were to be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions. Purchases of up to $500 billion in MBS were to be conducted by asset managers selected via a competitive process. Purchases of both direct obligations and MBS were expected to take place over several quarters.

In December of 2009, the Treasury Department quietly announced that instead of limiting its support to the GSEs to the previously-announced $600 billion, its support would be unlimited for the next three years.

Since the original program was announced in November of 2008, the Federal Reserve has actually purchased $152.4 billion of Federal agency debt securities and $970.3 billion of mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. The Fed said last month it will stop buying agency debt and MBS at the end of March. By then, the Fed plans to have bought about $175 billion worth of agency debt and $1.25 trillion worth of mortgage-backed securities.

GSE Share of Residential Mortgage Loans

The GSEs hold the largest share of single-family residential mortgages and home loans, including $5.1 trillion of loans that support the mortgage-backed securities they have issued and $446.4 billion of “whole” loans in their own portfolios. Combined, they account for approximately $5.5 trillion or 51% of the almost $10.9 trillion of single-family mortgage debt outstanding in the U.S. They are followed by Commercial Banks with $2.2 trillion (20%), Asset-Backed Securities issuers with $1.6 trillion (15%), Savings Institutions with $537.4 billion (4.9%), Finance Companies with $345.1 billion (3.2%) and Credit Unions with $318.4 billion (2.9%) (Figure 1).

The GSEs also hold the largest share of multi-family mortgage loans, with $197.4 billion of “whole” loans in their own portfolios and $162.2 billion of loans that support the mortgage-backed securities they have issued. Combined, they account for $359.6 billion or 39% of the $911.7 billion of multi-family residential mortgage debt outstanding. They are followed by Commercial Banks with $217 billion (24%), Asset-Backed Security issuers with $110 billion (12%), State and Local Governments with $66 billion (7%), Savings Institutions with $64 billion (7%) and Life Insurance Companies (6%) (Figure 2).

It is worth noting that the amount of single-family residential mortgage debt outstanding greatly exceeds the amount of multi-family residential mortgage debt outstanding, with multi-family mortgages representing only 7.7% of all residential mortgage debt outstanding. More importantly for this analysis, GSE single-family residential mortgage debt outstanding dwarfs the amount of GSE multi-family residential mortgage debt outstanding, with GSE multi-family mortgages representing only 6.5% of all GSE residential mortgage debt outstanding.

Multi-Family Debt Outstanding, Interest Rates and Equity Returns

While the Fed’s program was designed to hold down home loan costs and stimulate the economy, research suggests that it has had the ancillary effect of increasing the availability and reducing the cost of credit for the purchase of multi-family residential properties. This in turn has slowed the rate of increase in the Income Return for NCREIF’s multi-family property sector — a proxy for capitalization rates (cap rates) — compared with NCREIF’s other property sectors.

From the end of the third quarter of 2008 through the end of the third quarter of 2009, a period which encompasses the Fed’s program, GSE multi-family residential mortgage debt outstanding increased by 9.5% (Figure 3).

During the same four quarters, all multi-family residential mortgage debt outstanding increased by only 1% and commercial mortgage debt outstanding decreased by 1%.

As the outstanding GSE multi-family residential mortgage debt increased from the end of the third quarter of 2008 through the end of the fourth quarter of 2009, the cost of that debt decreased, with the interest rate on Freddie Mac’s 5-year fixed-rate loans declining by 90 bps, from 6.4% to 5.5% (Figure 4).

From the end of the third quarter of 2008 through the end of the third quarter of 2009, the Income Return for the NCREIF Apartment Sector increased 88 bps from an historic low of 4.45% to 5.33% (Figure 5).

This increase is less than the 116 bps increase in the combined Income Return for NCREIF’s Office, Retail and Industrial property sectors for the same period and would seem to reflect the impact of the increased availability and reduced cost of GSE debt on the Apartment sector.

Example From A Recent Transaction

A recent transaction highlights the impact of the increased availability and the lower cost of GSE debt for the multi-family sector. City Pointe is a five-story 183-unit apartment property that is well-located in downtown Fullerton, CA.

The property is subject to a $24,000,000 Freddie Mac floating rate loan that the seller recently put in place at a spread of 311 basis points over Freddie Mac’s Reference note, which is currently at 0.1%. This results in a highly-favorable current rate of 3.21%. The loan includes a 7% interest rate cap, a 5-year term, and can be paid off with a 1% penalty at anytime after November 2010.

Widely marketed by CBRE, the offering generated 50 property tours and 27 offers. About one-third of the offers exceeded $40 million. The bidders that submitted above $40 million included REITs, private buyers and exchange buyers. The property is expected to trade for approximately $42 million, which translates into an implied going-in cap rate of 5.25% on the nominal underwriting assumptions. On more realistic assumptions, we believe the expected purchase price will represent a going-in cap rate of approximately 4.9%.

Investment Implications

The analysis presented in this paper suggests that the Federal Reserve’s program to purchase the direct obligations of housing-related GSEs has increased the amount of GSE multi-family mortgage debt outstanding, lowered the interest rates on these mortgages and slowed the increase in income returns — and decrease in value — for multi-family properties. With the Fed’s recent announcement (January 2010) that it will stop buying agency debt and MBS at the end of March, it is reasonable to conclude that we may see a moderation in the positive effects on multi-family pricing. Combined with Federal Reserve Chairman Bernanke’s statement to the Financial Services Committee (February 13, 2010) about the Fed’s strategy for winding down the extraordinary lending and monetary policies that it implemented to combat the financial crisis, there is a greater risk that recent capital market trends for the multi-family property sector could reverse.

These considerations imply that current market conditions are providing a window of opportunity for multi-family residential owners to sell assets – whether to realize gains that have accrued to them over the past several years, pay down debt or increase liquidity. Surprisingly, the NCREIF Apartment Income Return is still only 88 bps above its all-time low.

Although the current economic and real estate market environment makes finding attractive multi-family investment opportunities difficult, prospective buyers should focus on properties characterized by strong and sustainable operating fundamentals – occupancy, rental rates, income and cash flow – that will offset the potential for cap rate decompression as the Fed’s support for the GSEs wanes.

Is There A Real Estate Bubble?

Editor’s Note: This is the second post for RealForecasts.com. For its second post, RealForecasts.com is re-publishing a white paper titled “Is There a Real Estate Bubble?”, which was written in September of 2005. Not only were there were bubbles in both the residential and commercial real estate capital markets, but the bursting of these bubbles that began in August of 2007 precipitated the greatest economic downturn in the U.S. since The Great Depression of the 1930s.

Is There a Real Estate Bubble?

By Jeffrey J. Peshut

September, 2005

The question on the minds of most real estate investors today is whether there is a “bubble” in the real estate capital markets and, if so, when will it “burst”. I wrote the [previous post titled “Will Market’s Boom/Bust Cycle Repeat?”] in mid-1998. The question then was whether there was a bubble in the stock markets and economy and, therefore, the real estate space markets. Hindsight tells us that there was in fact a bubble in all three, as these bubbles burst about 18 months later.

Is There A Bubble?

Those who argue that there are bubbles in both the residential and commercial real estate capital markets today make the following case:

– We are once again nearing the end of a “credit-fueled” bubble similar to the credit-fueled bubbles that ended during the late 1980’s and late 1990’s.

– The Federal Reserve and commercial banks cause these bubbles by artificially expanding the supply of money and credit. The Fed expands the supply of money and credit by buying Treasury Bills in the open market or by lowering the discount rate as a means of lowering short-term interest rates. This expansion of the money base is magnified by the impact of fractional-reserve banking.

– When the Fed pumps money into the economy, interest rates drop — at least at first.

– As the commercial banks’ reserves increase and interest rates decrease, businesses take out bank loans to invest in projects that weren’t profitable at the higher interest rates previously set by the free market. As businesses hire workers and buy equipment and raw materials to implement their investment plans, the economy picks up and the boom phase of the cycle begins.

– The boom, however, is founded upon an illusion. The government appeared to enlarge the pool of savings available for businesses to invest, but in reality it created money that didn’t exist before. It’s this money that was created “out of thin air” that creates the bubble.

– After all, the government can’t create wealth or real savings. It can only confiscate and redistribute existing wealth through taxation or inflation. When the Fed reduces interest rates by inflating the money supply, it in effect confiscates part of our wealth by inflation and lends our money to borrowers at the below-market rates referenced above.

– This subsidized interest rate sends a false signal to businesses, encouraging them to invest in projects that consumers weren’t in fact willing to pay for.

– Alas, all credit-fueled bubbles must end. Otherwise, we risk hyper-inflation or a collapse in the value of the dollar relative to other currencies.

– To end the bubble, the Fed must reverse its earlier policy and contract the supply of money and credit.

– During the late 1980’s, concerns about the rate of inflation for goods and services and a weak dollar lead the Federal Reserve to drastically tighten credit and end the bubble. During the late 1990’s, “irrational exuberance” in the stock market led the Fed to tighten credit and end that bubble. Today, concerns about a “housing bubble” and a weak dollar seem to be the impetus behind the Fed’s increasingly tight monetary policy.

– When credit-fueled bubbles end, they burst. And when they burst, the ill-advised investments that businesses made during the period of the Fed’s loose monetary policy are exposed.

According to this line of thinking, the question of whether the “bubble” in the real estate capital markets will “burst” becomes not “if” but “when”. And once it does, by “how much” will values decline.

If So, When Will It Burst?

To attempt to answer the “when” question, I offer the following observations:

– During the last “credit-fueled” bubble, the rate of growth in the money supply reached its peak in mid-1998 and its trough in late-2000. This correlates closely with the Fed’s “loose” monetary policy from early-1995 through early-1999 and its “tight” monetary stance from early-1999 through late-2000. See the following [Fed Funds Rate and REAL Money Supply (RMS) graphs. See also “The Mystery of the Money Supply Definition” by Frank Shostak (The Quarterly Journal of Austrian Economics Vol. 3, NO. 4 (Winter 2000): 69–76.) REAL Money Supply represents the true definition of the money supply outlined in Dr. Shostak’s article.]

– During what is arguably the most recent “credit-fueled” bubble, the rate of growth in the money supply reached a peak in early-2002 and again in early-2004, before beginning its current descent. Again, this correlates closely with the Fed’s loose monetary policy from late-2000 through early-2004 and its tight monetary stance since early-2004. It also correlates closely with the most recent run-up in prices in the residential and commercial real estate capital markets.

– Recently, [RMS has] been increasing at a decreasing rate. “Real [RMS]” ([RMS] adjusted for price inflation) correlates closely with changes in Industrial Production – a key measure of economic activity — with a 12-month lag. “Adjusted [RMS]” ([RMS] adjusted for price inflation and economic activity) correlates closely with changes in the stock markets, with a 4-month lag.

If past is prologue, the effect of the Fed’s current tight monetary stance on the money supply’s growth rate creates a significantly heightened risk of a slowdown in economic activity, a correction in the stock markets and a correction in the real estate capital markets in the year ahead.

How Much Will Values Decline?

With respect to the question of “how much” values will decline, the following observations are noteworthy:

– From 1995 through 2004, the spread between going-in cap rates and the 10-year Treasury averaged 320 bps.

– A year ago, going-in cap rates and 10-year unlevered IRR’s were 7.0% to 7.5% and 8.25% to 8.75%, respectively. These going-in cap rates represented a spread of approximately 280 to 330 bps over the 10-year Treasury, consistent with the historical average.

– Today, going-in cap rates and 10-year unlevered IRR’s are 5.75% to 6.25% and 7.0% to 7.25%, respectively, for “core” real estate investments. The going-in-cap rate represents a spread of approximately 155 to 205 bps to today’s 10-year Treasury.

– This spread is not only narrow for cap rates, but would also be narrow for commercial mortgage spreads. From 1996 through year-to-date 2005, the spread between commercial mortgages and the 10-year Treasury averaged 190 bps.

– According to L.J. Melody, today’s rates for fixed-rate commercial mortgages are 4.9 % to 5.5% for the four major property types. These rates represent a spread of 70 to 130 bps over the 10-year Treasury, approximately half the historical average.

– Therefore, it appears that last year’s cap rate levels were sustainable based upon historical averages but that the 125 bps decline in cap rates and IRR’s during 2005 will prove to be unsustainable.

– For a property with NOI of $5 million, a 125 bps increase in today’s going-in cap rates would result in a decline in value of 17% to 18%. It is important to note that this decline in value reflects only a return of the going-in cap rate spread to its historical average. It does not reflect a change in the 10-year Treasury rate.

– It is also important to note that a 17% to 18% decline in value requires a 20% to 22% increase in value to return to the value that existed before the decline.

One final observation: Once bubbles burst and market values decline, market values typically take a long time to recover. For example, five years after the bubbles in the stock markets burst, the Dow Jones Industrial Average is still only 90% of the all-time high it set in early-2000. Similarly, the S&P 500 Index and the NASDAQ Composite Index are only 80% and 45%, respectively, of their 2000 all-time highs. Therefore, once the real estate bubble bursts, it could take several years before real estate values return to the levels they achieved at the height of the bubble.